Hyper-inflation is not off the tableJanuary 27, 2009
I haven’t been shy about warning the dollar is doomed. The long run is fast approaching, but that doesn’t mean it will arrive tomorrow. It could, but it probably won’t. We have seen a powerful dollar rally over the last year and many people believe it will continue. I think they’re wrong. There are two ways a currency can lose value, inflation or hyper-inflation. People often consider hyper-inflation a “really bad” inflation, but it’s not, it’s a fundamentally different concept. Inflation is a deliberate act of policy, hyper-inflation is a black swan event. Inflation is monetary, hyper-inflation is psychological. Inflation is manageable, hyper-inflation is chaotic. It’s now fairly obvious to everyone that despite an expanding money supply the collapse of credit has caused a deflation-like environment. Prices are crashing everywhere. The economy in general is still way too levered so it’s difficult for me to believe this trend will reverse dramatically in the foreseeable future; despite almost free money everywhere banks are justifiably cautious and credit-worthy borrowers aren’t too excited about the prospect of new debt given economic and market conditions… All deflationary, all true… but none of it really matters. For the same reason short term treasuries had negative yields, as quickly as people stopped consuming, they can stop saving in dollars. Culture can change in a matter of weeks and investors have demonstrated a willingness to PAY for safety, it’s only reasonable to assume the same holds true for ordinary people. Even in a deflationary environment with the value of dollars going up, people will exchange those dollars for something perceived to be more safe despite the cost of missed potential appreciation and minimal interest. Commodity price trends and the availability of credit is not relevant to the hyper-inflationary debate, the only question is one of confidence. After 2008, nobody can argue people are unable or unwilling to modify their habits very quickly when psychology changes. The Wiemar Republic had a period of deflation immediately prior to their hyper-inflation, this is no time for complacency. If the economy recovers People often claim Americans will never lose confidence in the dollar because all their income and expenses are in dollars. I don’t care what Americans think, too many US dollars are held by foreigners. Americans are no longer masters of their domain. The US dollar is the global reserve currency, the first global reserve currency not backed by a commodity. To understand why foreigners may become willing to divest their dollars you must understand the critical distinction between the economic problems in America and Asia. Everyone is suffering from a lack of demand, but stimulating demand is much easier in Asia where many people have no possessions and lots of savings. How will Americans spend more when they’re already saturated with cars, televisions, electronics and still levered up to their eyeballs? The old game of Americans consuming and Asian producing is dead forever. The world doesn’t need America to consume on its behalf, re-modeling your kitchen does not create prosperity in Asia. If you expect the economy to eventually recover with a return of demand, it will come from abroad. So we must ask this important question: What will they buy? Other than Hollywood, bombs and claims of freedom, Americans have little to offer the world. It’s tough to see an economic recovery helping the US dollar without dramatic structural changes to the US economy, a significant increase in immigration, or a significant decline in living standards – none of which are out of the question. Should a recovery emerge as a result of some incredible technological breakthrough developed in the US and exported abroad, all bets are off. But how likely are these things, really? Normally this would simply require a re-balancing of global currencies, not the least bit hyper-inflationary, but in this case large reserves are held by a small number of people. A decision to dump by any one of them could precipitate a panic. There is no way to predict whether the dollar will suffer a steady decline or hyper-inflationary collapse, but I’m not taking any chances. A falling dollar is a falling dollar, gradual or not. If deflation or zero growth persists Without growth people will focus on safety. In 2008 this trend was a net-benefit for the dollar, but with eye-popping budget deficits around the corner that may not last for long. America has a questionable ability to repay its existing debts, let alone new debts inspired by double-or-nothing stimulus packages. Should they fail, not only will it mean more interest payments but combined with a persistently weak economy it further threatens the ability of government to raise revenue through taxation. If the economy is going to suffer anyway, surely it would be preferable to do so with less debt. Deflation kills debtors because it increases the amount of work required to earn the same number of dollars, plus interest. In other words, when a system is as debt dependent as the US, deflation is the opposite of safety. If you’re looking for safety in a deflationary environment, look elsewhere. Other than central bank reserves and speculation there is only one reason to hold the currency of another nation – to buy something produced in that country. If there is no safety and no technological breakthrough, for what purpose will foreigners hold US dollars at these ridiculous yields? No safety, no goods, no yield… no deal. The most significant unknown is how quickly people will react. Investors will liquidate their dollars first in anticipation of future declines, but this crisis will likely never reach hyper-inflation without foreign central banks playing ball. I am confident ordinary people will understand the impact of an insolvent US government, or at least its repercussions like an emerging gold bubble in the physical market, but I don’t know how quickly public pressure can force central bankers to act. Perhaps they never will, but I’m not taking any chances. The catch As bad as American prospects appear, it’s even worse in many places abroad. In other words, assuming my belief the dollar is doomed translates into stronger foreign currencies is misplaced. Obviously some will increase in value, particularly in Asia, but many will be debased in tandem with similar monetary and fiscal policies abroad. Debt is not exclusively an American problem. The US dollar may be as safe relative to some European currencies as US equities were relative to some European equities. They will all go down together, but some more than others. In that case, it’s best to avoid them all. There is no reason to expect an emerging dollar crisis to be contained within US shores. Conclusion Of course you know where I’m going with this, all roads lead to gold.
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“short term treasuries had negative yields”
I really am trying to understand this…does this mean in terms of keeping up with inflation? or the rising dollar?
“for what purpose will foreigners hold US dollars at these ridiculous yields?”
the rule of law???
I’m so naive.
A negative yield on a government bond means the investor is literally paying the government to hold their cash. The only logical reason to do such a thing is if you are running away from everything else, including corporate bonds, stocks, commodities, everything, even bank deposits because you are afraid the bank will go bankrupt (FDIC limits the insurance to $100,000 which is worthless for an institution with $1 billion). In other words, people would rather lose a little than accept any risk they could lose a lot. My argument is that phenomenon is no different than an individual losing faith in a currency despite deflation. You will pay a little in the short term to avoid the risk of losing everything.
“the rule of law”
There is a market for government bonds like anything else, if you own the bond you can sell it like somebody selling a stock. Also, they mature. Which means eventually the government must repay the face value of the bond. Right now, the US government has no reserves, the only way they can repay their creditors is by borrowing more. Some people describe it as a giant ponzi scheme. Technically they could cut spending or increase taxes, but that’s the opposite of “stimulus”. They could also just print it, like Zimbabwe.